Today, in a unanimous decision, the Supreme Court held in Merit Management Group, LP v. FTI Consulting, Inc. 1 that the “safe harbor” for settlement payments under Section 546(e) of the Bankruptcy Code does not bar a trustee from avoiding a transfer made through a financial institution intermediary when the “overarching” transfer that the trustee seeks to avoid was not made by, to or for the benefit of such financial institution or other entity to which the Section 546(e) safe harbor applies, but instead ultimately was made between two parties not otherwise shielded by the provisions of the statute.2 The Merit Management decision enhances a trustee’s ability to recover preferential or constructively fraudulent transfers in a bankruptcy proceeding and, thus, is likely to have substantial practical ramifications.

The Merit Management case arose out of an effort by an entity called Valley View Downs to develop a horse-racing track and casino in Pennsylvania. To increase its odds of securing the last available harness-racing license, Valley View decided to acquire its competitor, Bedford Downs Management Corporation. To consummate the transaction, Valley View entered into an escrow agreement and a settlement agreement by which Valley View agreed to pay Bedford Downs $55 million for all of its stock.

Merit Management Group, LP held about 30 percent of Bedford Downs’ stock, so it ultimately received around $16.5 million in the transaction. Valley View made the transfers to Merit through Credit Suisse, which was financing the acquisition as part of a larger transaction, and Citizens Bank of Pennsylvania, which had agreed to serve as a third-party escrow agent for the transaction. Credit Suisse wired the $55 million to Citizens Bank, which then disbursed the funds to the shareholders of Bedford Downs, including two installments totaling approximately $16.5 million, to Merit.

Valley View subsequently filed bankruptcy under Chapter 11. A litigation trust was created under Valley View’s confirmed plan to pursue specified avoidance actions. The trustee of the litigation trust sued Merit, and Merit moved for judgment on the pleadings, arguing that a safe harbor in Section 546(e) of the Bankruptcy Code prohibited the trustee from attempting to avoid the $16.5 million transfers.

Section 546(e) provides, among other things, that a trustee may not avoid “a transfer that is a . . . settlement payment . . . made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant or securities clearing agency, or a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract . . . .”

Merit argued that the $16.5 million was transferred “by or to” a financial institution because Credit Suisse and Citizens Bank transferred and received the funds in connection with Valley View’s acquisition of Bedford Downs’ stock. The trustee countered that the transfer was not “by or to” a financial institution because neither Credit Suisse nor Citizens Bank acquired a beneficial interest in the $16.5 million but instead were merely conduits for the transfer to Merit. The US District Court for the Northern District of Illinois ruled in Merit’s favor, holding that a transfer “by or to” a financial institution only requires that a financial institution send or receive the funds. The Seventh Circuit reversed, however, holding that Section 546(e) does not protect transfers in which financial institutions serve as mere conduits.

The Supreme Court affirmed the Seventh Circuit. The Court began its analysis by saying that “[b]efore a court can determine whether a transfer was made by or to or for the benefit of a covered entity, the court must first identify the relevant transfer to test in that inquiry.” In Merit’s view, the Court had to examine not only the “Valley View-to-Merit end-to-end transfer” but also its component parts, i.e., the transfer of the $16.5 million from Credit Suisse to Citizens Bank and the two installments Citizens Bank paid to Merit. Because those components included transactions by and to financial institutions, Merit argued that Section 546(e) precluded avoidance. The trustee argued, however, that the only relevant transfer was the ultimate transfer between Valley View and Merit of the $16.5 million for the purchase of Bedford Downs’ stock.

The Supreme Court agreed with the trustee. It reasoned that the text and structure of Section 546(e) makes clear that the safe harbor “applies to the overarching transfer that the trustee seeks to avoid, not any component part of that transfer.” In other words, “the pertinent transfer under [Section 546(e) is] the same transfer that the trustee seeks to avoid pursuant to one of its avoiding powers.” The Court noted that the trustee cannot define the transfer it seeks to avoid in any way it chooses but instead must identify a transfer that satisfies the terms of the avoidance provision that the trustee invokes. Once the trustee does that, then a court has no basis to examine the component parts of the transfer, which, in the Court’s words, are “simply irrelevant to the analysis under [Section 546(e)].”

Merit also argued that the parenthetical “(or for the benefit of)” in Section 546(e) means that to qualify for the safe harbor, it is unnecessary for the financial institution to have a beneficial interest in the transferred assets. By that reasoning, Merit argued that a transaction “by or to” a financial institution, i.e., Credit Suisse and Citizens Bank, would qualify for the safe harbor even if the financial institution is acting as an intermediary without a beneficial interest in the transfer. The Court again disagreed, reasoning that the parenthetical exists to track the substantive avoidance provisions. By way of example, the Court observed that a trustee seeking to avoid a preferential transfer under Section 547 that was made “for the benefit of a creditor,” where that creditor is a covered entity under Section 546(e), cannot elude application of the Section 546(e) safe harbor merely because the transfer was not “made by or to” that covered entity.

The Court’s decision leaves unresolved multiple potentially significant issues regarding its possible application to public trading in equity or debt securities. First, the Court noted that the parties did not argue that either Valley View or Merit qualified as a “financial institution” under the Bankruptcy Code, which generally not only covers a bank acting for its own account but also refers to the bank’s “customer” when the bank is acting as agent or custodian for a customer in connection with a securities contract. Accordingly, the Court did not address whether a party’s status as a customer of a financial institution could affect the application of Section 546(e). Second, the Court did not address whether the transaction at issue actually qualified as a transfer that is a “settlement payment” or made in connection with a “securities contract” within the meaning of Section 546(e). And, third, the Court noted (albeit in dicta) that if a trustee seeks to avoid a transfer “by or to (or for the benefit of)” a securities clearing agency, then Section 546(e) “will bar avoidance, and it will do so without regard to whether the entity acted only as an intermediary.” Given these limitations, much remains to be seen as to the decision’s impact in the context of public transactions relating to equity or debt securities, including transactions clearing through securities clearing agencies or ultimately made through custodial or brokerage accounts maintained at financial institutions.

Notwithstanding the unresolved issues, today’s decision may still have a variety of practical implications. The decision enhances a trustee’s ability to recover fraudulent transfers and increase the bankruptcy estate’s leverage with respect to recipients of pre-petition transfers. Additionally, leveraged buyouts and other securities transactions, particularly of privately held companies, may be more vulnerable to being unwound. And, finally, the decision may broaden the universe of potential defendants in avoidance actions to include investors, investment funds and similar entities. By virtue of the factual posture of the case, the Supreme Court did not resolve these issues, and it remains to be seen what implications Merit Management may have on these issues.

Any questions about the case should be directed to Thomas (Tom) Kiriakos (312-701-7275) or Sean Scott (312-701-8310) in our Chicago office.

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